Embraer SA Is Back on Track

Regional aircraft manufacturer Embraer SA gave shareholders a bumpy ride in 2013. Many investors were concerned about Embraer's slowing pace of aircraft deliveries, along with its falling order backlog.

After securing several major aircraft orders in 2013 and delivering a strong earnings result in Q4, Embraer has put the bears' fears to rest. Sales in the commercial jet division -- which accounts for a little more than half of the company's revenue -- should remain steady for the next several years. This will tide the company over until its next-generation E-Jets arrive in 2018, bringing a big opportunity for renewed growth.

Rebuilding the order backlogAt the beginning of last year, Embraer faced serious questions about its order backlog. Whereas Embraer had delivered 106 commercial jets in 2012, the company had firm orders for just 185 additional commercial jets by the end of that year, representing less than two years of production.

Barring new orders, it appeared that Embraer would soon need to slow its production lines. Sure enough, Embraer only managed to deliver 90 commercial jets in 2013. However, strong demand for large regional jets in the U.S. allowed Embraer to rebuild its backlog during the year.

In April, United Continental placed an order for 30 of Embraer's E-175 regional jet, which seats 76 passengers in United's configuration. Less than a month later, top regional airline SkyWest announced a firm order for 40 E-175s, which will also be operated for United under the United Express brand. These United Express E-175s are scheduled to go into service in May, and deliveries will be complete by the end of 2015.

Embraer's E-175 was a big seller in the U.S. last year. Photo: Embraer.

SkyWest's purchase agreement also includes conditional orders for 60 more E-175s, contingent on SkyWest winning more regional flying contracts. As SkyWest is the largest regional airline in the U.S., there is a decent chance that it will firm up some of those orders in the next few years.

In December, Embraer got another big win as American Airlines ordered 60 E-175s for its regional operations. These planes will start arriving in Q1 2015. These deals -- along with an earlier agreement by Republic Airways to buy 47 E-175s that will fly under the American brand -- total 177 firm orders: nearly two full years of production!

By the end of 2013, Embraer had firm orders for 429 commercial aircraft, of which 279 are for the current generation of E-Jets. Excluding a JetBlue order that was deferred to 2020, Embraer has 255 E-Jets scheduled for delivery in the next several years. Embraer only needs to add another 150-250 orders to its backlog in the next few years to sell out its production slots (at the recent 90-95 aircraft per year pace) until the next-generation E-Jets are rolled out between 2018 and 2020.

Financial results stay strongWhile worries about Embraer's backlog subsided during 2013, many investors were still concerned that the company was not producing enough aircraft to maintain its profitability. Embraer dispelled those concerns with a strong Q4, in which it produced adjusted earnings before interest and taxes of $315.9 million. That represented more than half of its full-year adjusted EBIT of $566.4 million.

Lower commercial jet production was offset by revenue growth in Embraer's defense and executive jet businesses. Cost cuts and a decline in the Brazilian real helped to bolster Embraer's profit margin. Embraer expects fairly similar revenue and margin results in 2014 as a shift to less profitable models in the commercial jet business segment will be offset by efficiency gains and better results in the defense and executive jet segments.

Waiting for 2018For the next few years, Embraer may be stuck in a bit of a holding pattern. While there may be a few more regional airline deals to be had in the U.S. in the near term, Embraer's next major growth driver will be the introduction of its second-generation E-Jets near the end of the decade.

The new E-Jets are expected to provide a 16%-23% improvement in fuel economy compared to first-generation E-Jets. The new generation will also provide better market coverage with fewer models, by phasing out the less popular E-170 and lengthening the E-175 and E-195 models. This will place the E-175, E-190, and E-195 capacities at roughly 20-seat increments from each other, allowing Embraer to seamlessly cover most of the 70- to 130-seat jet market.

Embraer has already seen a strong response to the new jets, winning two firm orders totaling 150 jets within a month of the product launch last year. Embraer added another 50 firm orders last month from Air Costa, a new Indian airline start-up.

As the entry-into-service of the new jets nears, orders should keep piling in. Ultimately, demand for the second-generation E-Jets is likely to outstrip demand for the first generation, leading to higher production rates and higher profits by 2020. For investors with a long-term mind-set, buying Embraer and holding past the end of the decade could be very rewarding as the arrival of the new E-Jet models drives accelerating earnings growth.

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